Considering the Pros and Cons of Refinancing Your Home?
Maybe you’re wondering if a refinance will drop your monthly payment?
The pros and cons of refinancing must be considered before you get started!
You might shortening your loan, saving you tens of thousands of dollars! Or you may just want to drop PMI or just get a better interest rate.
There are some great reasons to refinance. But there are also definitely some things to avoid.
A home refinance can be a great way to lower your payment. It can also reduce your interest rate or enable you to pay the home off faster.
It’s also important, however, to avoid some of the common pitfalls that many home owners fall into when doing a home refinance.
In this post, we’re taking the myserty out or mortgages, refinancing and when & how to do them.
Specifically, we’re looking at all the big pros and cons of refinancing your home so you can make the right decision for your home.
What does refinancing a home mean?
This is your existing mortgage (which is just a fancy word for a loan).
Then you work with a new lender (or the original mortgage company) to renegotiate the terms of your loan.
Most of the time you can expect to pay a few thousand dollars in the negotiation process.
So we want to review the pros and cons of refinancing your home to make sure it makes good financial sense over the long term.
First we need to identify your goal and see if it makes sense in the pros and cons of refinancing your home:
As I said, you might want to:
- Lower your interest rate (rates are currently below 4% and you can always see the current rates no matter when you read this post by checking out MarketWatch)
- Lower your monthly payment – Lowering your interest rate will drop your monthly payment. If, however, you are currently paying PMI (Private Mortgage Insurance) and your home has gone up in value since purchase, you may be able to refinance and get rid of the PMI payment. This is likely adding $100 or more per month to your payment)
- Get a shorter loan term – Most homeowners go for 30 year loans and most of us grew up just thinking that was how it was done. In reality you can get a loan for almost any length of time. A 15 year loan will save you big bucks over the life of your loan depending on the home price. That money, if invested in mutual funds, could bring you millions for retirement. A great alternative to giving it to the bank!
- To move to a fixed rate loan – If you are currently on an adjustable rate or an interest only loan you are seriously jeopardizing your family’s financial future. Moving to a fixed rate loan could literally be one of the best decisions you ever make.
- Cash out equity – Equity is the amount of money your home is worth over how much you owe on it. If it’s worth $200,000 and you owe $150,000, your equity is $50,000. This is my least favorite of the reasons. Going this route, you are essentially borrowing money and using your home for collateral; meaning if you default on the payment you could lose your home. There are a lot of ways to improve your monthly cash flow. Saving for big purchases is always preferable to borrowing money, but if you are going to do this we need to be smart about it.
Is it bad to refinance?
Generally speaking you should only consider the pros and cons of refinancing your home after you’ve been in the home at least 2 years.
You also want to make sure you plan to stay in the home at least another 5 years.
We’ll get into that more below.
Lastly you need to have a clear goal for your home refinance.
Whatever your reason to refinance, you want it to make sense financially. A lower interest rate, lower payment or dropping PMI might all be great reasons to refinance.
But before you rush off to call a loan officer, let’s dig into all the pros and cons of refinancing your home and examine each one as it pertains to you and your situation.
— Moneywise Family (@MoneywiseFamily) November 8, 2016
So let’s look at each of the pros and cons of refinancing your home, one by one
PROS OF REFINANCING
1. Lower Your Interest Rate
Generally speaking if you can lower your interest rate by half a percentage point (or more), it’s probably worth doing.
For instance, let’s say you bought the house 8 years ago on a 30 year fixed loan and at that time you got a 5.25% interest rate.
Chances are at today’s rates, you could drop that to 3.99%, saving you 1.25%.
Say you refinance the balance of what you owe ($150,000). Over the course of 30 years from that point forward, that change in interest rate will literally save you about $40,000. (factored using the mortgage calculator at www.mortgagecalculator.org)
Dropping your interest rate is certainly one of the top pros of the pros and cons of refinancing your home.
2. Lower Your Monthly Payment
We know lowering the interest rate can save you cash, but what about just doing a home refinance to lower your monthly payment?
Aside from interest rate, you can also lower your monthly payment by eliminating PMI which as I noted above is Private Mortgage Insurance.
This is insurance your lender (the company giving you the money to buy or refinance your house) requires when you owe more than 80% of your home’s value. And they make you pay for it. It insures them in case you default on the payment (stop paying your monthly payment).
In a nutshell if you buy a $200,000 house, and your loan amount is over $160,000 you will have to pay PMI.
PMI typically adds about $120 to your monthly payment on a $200,000 loan. Check your specifics by using this PMI Calculator by GoodMortgage.
That’s a savings of $1,440 per year! That might be worth doing
Getting rid of PMI without going thru a refi
PMI doesn’t just automatically drop off your mortgage when your home value goes up.
Depending on your loan terms it will, however, likely drop off when you have paid down the loan principal enough to where the LTV (loan to value) gets better than 80/20 (where you owe less than 80% of the home’s value).
But for many of us, the home value is increasing faster than our loan principal is going down. In which case a refi to get rid of it might make sense.
However, you may be able to request it be dropped by your current company without going through the hassle and expense of a refi.
But in order to prove your case you’ll likely have to pay for your home to be appraised by a professional appraiser.
Before you pay for this you’ll want to contact your current mortgage company and ask if this is possible and find out what they need specifically to make this happen.
Need more on this? Check out the government’s page on PMI at the Consumer Financial Protection Bureau.
Getting rid of PMI, which only benefist the lender, is definitely a good pro in the pros and cons of refinancing your home.
3. Get a Shorter Loan Term
Nothing sheds tens of thousands, if not hundreds of thousands off your mortgage more than shortening the loan term.
Back in the “old days” everyone just got a 30 year fixed rate mortgage and that was considered “normal”.
However you need to understand that your are paying compound interest over decades. In doing so, you begin to realize that the $200,000 mortgage you just took out will actually have you paying back almost $348,000 (factored using the MortgageCalculator.org).
Thus, cutting your loan term down by ANY amount can save you a lot of money. This is my favorite in the list of the pros and cons of refinancing your home.
How the math works on reducing the length of your loan
Just as a for instance, if you took that $200,000 loan from a 30 year down to a 15 year, you would only be paying back $266.287.
Saving almost $82,000 is a good reason to refinance!
Now, I know some of you are thinking that going from a 30-year mortgage to a 15 year means your payment doubles.
As crazy as it might sound, that is not correct.
While it’s true it will be higher, it may be a manageable increase and worth some cut backs to save that $82,000! No; going to a 15-year loan means a monthly payment of about $1,479/month. That is versus the $955 it was at a 30 year.
Yes, a monthly payment difference of about $500 can save you $82,000!
To keep things a little simpler, all my mortgage calculations are with principal and interest only. Thus I’m not factoring in things like property tax and home owner’s insurance, all of which can vary a lot from place to place.
Also, know that you’re not locked in to only 30 or 15. If you can afford a 7 year or less; go for it! Can’t quite make the mortgage payment work at 15 years? Ask about doing a 20!
Want to dive in deeper on the benefits of Paying Off Your Mortgage Faster? I have a highly shared post on that very subject. Take a moment and review if you want to learn more.
4. Get a Fixed Rate Loan
A fixed rate loan should be the only type of loan you consider.
Thankfully one of the benefits of the crash of 2008 is that many of the riskier loan types aren’t pushed nearly as hard now.
But if you got your loan before that, it’s possible you have an adjustable rate mortgage or an interest only mortgage.
Let’s review why these are a TERRIBLE IDEA.
An interest only loan is literally just that.
You are paying the bank the interest (profit) only, for a set period of time, and not putting anything towards the principal (the amount you actually owe). Imagine buying groceries each week.
You give the store $100 each week and then at the end of the year you have to pay $5,200 because that $100 you gave them each week was just for the privilege of shopping with them.
That’s EXACTLY what an interest only loan is.
Would you even consider that?? I hope you answered no.
Adjustable rate mortgages are the financial equivalent of Russian Roulette.
You are simply gambling on how much and when your interest rate will go up. Maybe it will only go up a percent or 2 after a few years.
But depending on your terms, in 7 years it could double and at that point you might not be able to afford the payment and you could literally lose your home.
I still recall when I was in my early teens and the home my mother had purchased went up to almost 14% interest and we had to sell it.
That was because of her adjustable rate mortgage and the crazy economy in the early 1980’s.
Don’t gamble on your family’s future! If you have one of these loans, now is the time to ditch them. If you don’t have one; keep it that way!
So getting rid of an adjustable rate or interest-only loan is probably the #1 pro in the pros and cons of refinancing your home.
5. The H.A.R.P. Program
HARP (the Home Affordable Refinance Program) was created by the Federal Housing Finance Agency.
It is specifically designed to help homeowners who are current on their mortgage payments, but are upside down. By that I mean they owe more on their home than it is now worth.
In a traditional refinance setting you would not be able to refi if you are upside down on the home’s value. Thus the HARP program could be a great way to reduce your interest rate if that’s the boat you’re in.
Learn more and see if you qualify on the government’s HARP Page.
CONS OF REFINANCING
6. Cash Out Equity
As I mentioned, this is my least favorite of the pros and cons of refinancing your home although it’s widely done.
Essentially you are borrowing money using your home as collateral.
Now, since you already have a home loan, you are technically already doing that. The key difference, however, is that your original loan was for the home by itself.
Taking out equity loans are often done for a variety of reasons outside of just paying for the home. Reasons range from paying for remodels to vacations to paying off other debt.
The reason I don’t like this is that you are increasing the amount of money your home is borrowed against.
This means it will take longer to repay. Unless you are also dropping your interest rate significantly, you are also increasing the monthly payment.
The danger then becomes that if there is a change in employment or income, the new higher payment can be harder to meet each month and the risk of losing your home to foreclosure increases.
If you insist on doing a home equity refi the only way I would personally be OK with it is if you are:
- Adding to the value of the home (genuine home improvements that boost home value, such as these mentioned by Realtor.com)
- Using the money in a way that generates additional income (eg: you or your spouse going back to finish a degree that has a high probability of significantly improving household income)
I would never recommend doing a cash out refi to:
- Pay for things that go down in value (cars, boats, campers, etc)
- Loan money to friends of family (do you really want to lose your home bailing Uncle Johnny out of jail?)
- Pay for frivolous things that don’t bring value to your home or income (vacations, cosmetic surgery, etc) – that’s what being frugal and saving money and working hard is for
Lastly, on this subject, I would also encourage you to check with your local credit union about a Home Equity Line of Credit.
As I go into further below, a refi will cost you between 3-6% of the total loan value.
So if you owe $150,000 and want to take out an additional $40,000, your new loan is $190,000. 3%-6% of that is $11,400.
That’s a lot to pay for the privilege of borrowing money even if it’s for one of the better causes I mention above.
My local credit union is currently offering Home Equity Loans for as little as 2.75%.
Of course the amount I borrow and my credit will be factors, but even at 3%, I’m only paying $1,200 to borrow that same amount of money.
Unless you are also dropping your interest rate and maybe dropping PMI, just doing a refi just for equity is probably a terrible financial idea.
If you own your home some of the processes or terms can be confusing.
I encourage you to check out my previous post called 9 Key First Time Home Buyer Steps You Must Take That post covers the entire process and terms in-depth. It breaks everything down so that even a novice can become an expert!
7. If you plan to be in your home less than 5 more years
Many of us had grandparents or great grandparents who lived in the same house decade after decade. Maybe they still live it the same house you remember as a kid.
That, however, is not the reality of the current generations.
According to the National Association of Home Builders, the average length of time a home owners stays in their home is about 15 years.
For first time home buyers, that time is even less. So you will likely live in your home 15 years minus however long you’ve already been there.
As we get into below, in most cases it will cost you more (in fees) than you will save (on your new monthly payment) to do a refinance if you are likely to move in fewer than 5 years.
Thus this is also one of the biggest cons in the pros and cons of refinancing your home list.
8. Longer approval time
Before the economy tanked in 2008 it was common for new home loans and refinances to take up to 30 days.
These days that process can be considerably longer. If you recently changed jobs, have poor or mediocre credit or a variable income, expect it to be even longer still.
Thus expect your refinance to take up to 90 days. Of course your lender can give you a more accurate estimate. But in my experience, it still often takes a little longer than they initially project.
9. The Streamline Refinance Program
The streamline refinance program is a government program.
If you have bad credit and your home is underwater then you might move this to the pros section of the pros and cons of refinancing your home.
But for most people with decent credit, you will save more with a traditional refi.
They sell the program as having no or low fees, no credit check, etc. Sounds great, right? It does until you consider the interest rate is higher than a traditional refi to cover that expense and risk.
So in most cases this is a con, not a pro. Underwater on your home, the HARP Program is probably a better option than this.
Is it worth it to refinance?
In the case of looking at any of the above pros and cons of refinancing your home, we need to make sure it makes sense monetarily.
It can be all too easy to see the potential savings of a lower interest rate or payment. But don’t forget about how much it’s going to cost you to do a home refinance.
How much it costs you and how long it takes to make that back is the best way to decide if a refi is right for you.
This is the most important of pros and cons of refinancing your home!
How to calculate whether a home refinance makes sense for you
Let’s say you owe $200.000 on your home and it’s now worth $300,000.
We can already tell from those numbers that we can drop the PMI we are paying. That alone saves us up to $120/month or over $1,000/year.
Doing a traditional home refinance will cost you between 3% and 6% of what you owe on your current loan.
Those figures and some great detail on doing a refi can be found on the Federal Reserve’s page. For our purposes, let’s assume the cost will be right in the middle, 4.5% on that $200,000 loan or $9,000. In my experience having done home refinance several times, that amount is about right.
So we now know we need to save at least $9,000 to make this home refinance make sense.
Quite simply, divide the total costs of the refi ($9,000) by the monthly dollar savings the refi gets you.
If you’re doing the refi to take out cash or shorten the loan period then this doesn’t apply to you. In this case, you aren’t doing the home refinance to save money on your monthly payment.
So in my original example, dropping the interest from 5.25% to 3.99% on a $200,000 loan balance nets you a monthly savings of $151.
That’s not including possibly dropping PMI and saving up to an additional $120/month.
So $9,000 divided by $151 is 59. That’s how many months of new lower payments it will take to recoup your expenses, or (divided by 12) about 5 years.
Plan to be in the house at least another 5 years? Then under the scenario of my example numbers, it would make good financial sense to do a home refinance.
Before you dig in on the pros and cons of refinancing your home make sure your finances are in shape!
Need help getting your family’s monthly finances on track?
I have a copy of my Budgeting Spreadsheet available at no charge!
It’s a simple, highly customizable, Excel spreadsheet and you can download it quickly and easily FOR FREE!
If you struggle each month, aside from being on a written budget like my spreadsheet provides, you might also want to check out one of my previous posts called 7 Best Ways to Stop Living Paycheck to Paycheck
A home refinance can definitely help get your finances in order. But nothing does the job quite a well as 2 people working together with a plan and some organizational systems!
So let’s review the . . .
9 Top Pros and Cons of Refinancing Your Home You Must Know!
- Understand your goal in doing a home refinance
- If you are doing the refi to lower your interest rate, make sure you can lower it by at least .5%
- If you think your home has gone up in value enough to drop PMI, see if you can get that dropped by your current mortgage company without the hassle and expense of a refi (not sure? Ask a Realtor friend to run “comps” in your neighborhood to see what “comparable” houses are selling for)
- Make sure if you are doing the refi to lower interest rates or payments that you can cover the cost of the home refinance in the remaining time you plan to live in the home (ideally you should recoup the savings within 5 years)
- If you can make it work, go for a 15-year loan rather than a 30, but even a 20 year is an improvement!
- NEVER do an interest only loan
- NEVER do an adjustable rate loan
- If you are doing the refi to take out equity, understand that you are essentially taking out a loan on your home and if you have any trouble making the increased payment, that can put your home in jeopardy.
- That being said, if you insist on using your home to borrow money, make sure the refi is the best option as a home equity line of credit from your local credit union might cost you less
Are you looking at the pros and cons of refinancing your home?
In this post, we took an in-depth look at the sometimes confusing world of home refinancing.
We looked at all the best options out there and what pitfalls to avoid.
Specifically, we looked at the top pros and cons of refinancing your home so you can decide if a refi is right for your situation.
Do you have questions? Have you done one and had issues? Done one and had it meet your goals?
Feel free to comment here or email me with any questions as I am here to help!
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Photo credits (that aren’t mine):
Monopoly houses and dice – https://www.flickr.com/photos/wwworks/
Growing Money – https://www.flickr.com/photos/[email protected]/
While I have years of successful financial & budgeting experience and run several million dollar businesses and handled the accounting, P&L and been responsible for the financial assets of them, I am not an accountant or CPA. Like all my posts, my posts are my opinons based on my own experience, observations, research and mistakes. While I believe all my personal finance posts to be thorough, accurate and well-researched, if you need financial advice, you should seek out a qualified professional in your area.